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FNCE 4070: FINANCIAL MARKETS
AND INSTITUTIONS
Lecture 1: Introduction to Financial
Markets
Professor Michael Palmer
Professor of Finance
University of Colorado at
Boulder
Summer 2012
Where is this Financial Center?
Beginning Quotes For Course
“May you live in interesting times.”
Reputed to be an ancient Chinese proverb and curse
“The only certainty in financial markets is uncertainty”
Credit Suisse, August 16, 2007 (Switzerland's second largest bank)
“Markets are constantly in a state of uncertainty and flux and money is made
by discounting the obvious and betting on the unexpected.”
George Soros (Hedge fund manager and philanthropist)
“Without the element of uncertainty, the greatest business triumph would be
dull, routine, and eminently unsatisfying.”
J. Paul Getty (American industrialist, founder of Getty Oil)
“I used to be scared of uncertainty; now I get a high out of it.”
Jensen Ackles (Actor. TV; Smallville, Dawson’s Creek, and Supernatural)
Your Understanding of Financial Markets?

What is a central bank (e.g., the Federal Reserve)
responsible for?



How does a central bank attempt to influence economic
activity?




How can we measure economic activity?
Who is the current chairman of the Federal Reserve and
who were the two previous chairs of the Federal
Reserve?


What the difference between monetary and fiscal policy?
What do we mean by quantitative easing (QE)?
Bank of England? European Central Bank?
What is the EU and what is the Euro-zone?
Which countries make up the; G7; PIIGS; BRICS
Which country, among the following: currently has the
highest (lowest) interest rate? United States, United
Kingdom, Japan, Germany, Australia, or Switzerland.
Ben Bernanke: The 14th Chairman of the
Federal Reserve Board

Ben Bernanke replaced Alan Greenspan on February 1,
2006


Background: The Chairman of the Federal Reserve
Board is named by the President and is confirmed by the
U.S. Senate.


Greenspan had served since August 1987.
They serve a term of four years, and can be reappointed.
The Federal Reserve is responsible for the conduct of
monetary policy, which means:


Setting interest rates and promoting money supply growth,
in pursuit of maximum employment, stable prices (now
defined as 2%), and moderate long-term interest rates.
See Appendix 1 for some insights into Bernanke and
Appendix 2 for previous Fed Chairs
Ben Bernanke (?) in Song

Columbia Business School's YouTube Video parody of
Dean Glenn Hubbard (Note: he is not the real Dean)
singing about Ben Bernanke.


http://www.youtube.com/results?search_query=ben+bernanke+every+b
reath+you+take&aq=0 (link to Ben Bernanke Every Breath you Take
video)
http://youtu.be/3u2qRXb4xCU (this may work as well).

As you watch and listen take note of the following terms:






1. Change of rate (i.e., interest rates)
2. Stagflate (aka, stagflation – a recession with inflation)
3. BPS (basis points, a measure of interest rates)
4. Yield curve flips (yield curve going from upwards sweeping to
downward sweeping as a signal of a future recession)
5. Interest rate policies (monetary policy used by central banks)
6. Models break (i.e., econometric models used to assess the
impact of monetary policy changes on the economy)
Federal Funds Rate



The Fed Funds Rate is the short term (generally
overnight) interest rate in the U.S. interbank market for
lending/borrowing “excess” bank reserves.
 What are excess reserves?
Essentially, the Federal Funds rate is the interest rate at
which one commercial bank will lend excess reserves to
another commercial bank.
The Federal Funds Rate is regarded as a key (i.e.,
“benchmark”) short interest rate in the United States
because the Federal Reserve sets this rate so as to
implement monetary policy.
 So we (financial market participants) get important
signals from this rate (and changes in the rate).
Federal Funds Rate

Since 1982, the Fed has announced a “target” for
the federal funds rate.
 However beginning in December 2008 the
target has actually been a range (upper and
lower limit).
 In addition to the Fed Funds target, another
important overnight interbank rate is the “effective
federal funds rate.”
 This is the actual rate at which banks are
lending excess reserves to one another.
 It will generally parallel the target, but when it
doesn’t it too provides us with important signals
as to conditions in financial markets.
How Does the Fed Affect the
Federal Funds Rate?

Through open market operation:


Buying government securities increases bank
excess reserves.


The buying and selling of government securities.
An increase in the supply of bank reserves (everything
else equal) will put downward pressure on the Federal
funds rate.
Selling government securities reduces bank
excess reserves.

A decrease in the supply of bank reserves (everything
else equal) will put upward pressure on the Federal
funds rate.
Demand and Supply Model of Bank
Excess Reserves: Impact on Fed
Funds Rate
Fed selling government
Fed buying government
securities; increasing
bank excess reserves
S1 S2
Fed
Funds
Rate
(%)
Demand
Excess Reserves
securities; reducing bank
excess reserves
S2 S1
Fed
Funds
Rate
(%)
Demand
Excess Reserves
U.S. Federal Funds Target Rate: Sep
1982 (first used) to Dec 2008

Note: Fed targeted money supply from 1979 to 1993, but, in 1982, it
started shifting policy towards the fed funds rate; in 1995 it formally
announced a fed funds target
U.S. Federal Funds Target Rate
Range: Dec 2008 to the Present

Beginning in December 2008 (Dec 16th) the Federal Reserve
announced a range for the Fed Funds Rate (0.00% to 0.25%).
Effective Federal Funds Rate

Historical high (Daily data): April 10, 1980, 19.53%.
Historical low: Dec 30, 2011 – January 2, 2012, 0.04%
Relationship of Target to Effective Rate

Note: An official fed funds target was first announced in1995,
although minutes from the FOMC suggests the Fed was targeting
this rate from 1982 on.
Monitoring the Effective Federal
Funds Rate

As noted, the effective federal funds rate
follows the target (or range) and thus it would
appear that we can monitor this rate as an
indicator of the stance (and changes in the
direction) of Fed policy.

http://www.bloomberg.com/apps/quote?ticker=FEDL01:IND

We can also evaluate the effective rate in
relation to the target or range as indicators
(signals) as to conditions in financial markets.
0
2008-01-02
2008-01-09
2008-01-16
2008-01-24
2008-01-31
2008-02-07
2008-02-14
2008-02-22
2008-02-29
2008-03-07
2008-03-14
2008-03-21
2008-03-28
2008-04-04
2008-04-11
2008-04-18
2008-04-25
2008-05-02
2008-05-09
2008-05-16
2008-05-23
2008-06-02
2008-06-09
2008-06-16
2008-06-23
2008-06-30
2008-07-08
2008-07-15
2008-07-22
2008-07-29
2008-08-05
2008-08-12
2008-08-19
2008-08-26
2008-09-03
2008-09-10
2008-09-17
2008-09-24
2008-10-01
2008-10-08
2008-10-16
2008-10-23
2008-10-30
2008-11-06
2008-11-14
2008-11-21
2008-12-01
2008-12-08
2008-12-15
2008-12-22
2008-12-30
Assessing Financial Market Conditions
in 2008
Target Fed Funds Rate Versus Effective Federal Funds Rate
4.5
4
3.5
3
2.5
2
1.5
1
0.5
Effective Rate
Target Rate
Assessing Financial Market Conditions with
the Fed Funds Range, Dec 2008 to the Present

Recall, beginning on December 16, 2008 the Federal Reserve
announced a range for the Fed Funds Rate
Why is the Fed Funds Rate
(Potentially) So Important?

Fed Funds rate is set (or influenced) by
U.S. central bank and thus it carries
important signals for the market.



It tells us what the central bank thinks
about the economy and the direction of
the economy.
These signals, in turn, will affect how the
market sets its interest rates.
Bottom line: Other money market rates
are probably influenced by the direction
and level of the Fed Funds Rate.
Prime Interest Rate


Prime Rate: Interest rate commercial banks
will charge their best customers (i.e., high
grade corporates) on loans to borrow short
term (one year or less) funds.
By convention, the prime rate is tied to the
Federal Funds Rate (with the Fed funds rate
the casual rate).



Banks scale up from this “cost of funds” rate.
Prime rate is generally around 300 basis points
higher than fed funds rate
Currently: 3.25%. (January 2008: 7.25%)
Fed Funds Rate and Prime Rate
Prime Interest Rate, 1955 - Present

Historical high (daily data): December 16, 1980 – January 1, 1981,
21.50%. Historical low: December 16, 2008 – Present, 3.25%
(matching August 1955)
Fed Funds Rate and Other Money
Market Rates
Fed Funds Rate and Capital
Market Rates
Fed Funds Rate and Equities
Measures of Economic Activity

Important measures of economic activity:

Economic output (Business Activity).


Business Cycles:
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Traditional recession definition: 2 consecutive quarters
decline in real GDP
Current definition: incorporates more analysis.
Most recent U.S. cycle:


GDP (changes in real GDP)
Recession: December 2007 - June 2009
Price levels

Inflation (Consumer and producer prices)
U.S. Business Cycles, June 1854 –
June 2009 (NBER Data)
Cycle Dates
Average Recession
(Months)
Average Expansion
(Months)
1854 – 2009 (33 cycles)
16 months
42 months
1854- 1919 (16 cycles)
22 months
27 months
1919 – 1954 (6 cycles)
18 months
36 months
1945 – 2009 (11 cycles)
11 months
59 months
Great Depression:
August 1929 – March
1933
43 months
Longest Expansion:
November 2001 –
December 2007
120 months
Recent U.S. Cycles
Federal Funds Rate and Business
Activity: Response of Federal Reserve
Equities and Business Cycles
Corporate Profits and Equities
Effective Federal Funds Rate and
Price Changes (Inflation)
Federal Reserve Discount Rate

Federal Reserve Discount Rate: Interest rate the
Federal Reserve will charge member banks and
other depository institutions to borrow short term
(overnight) reserves.



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Administratively set by the Federal Reserve
Currently: .75% (January 2008: 4.75%)
Historically called the Discount Rate, now called the
Primary Credit Rate.
This market is important as it represents a
“safety” net for financial institutions.
Also carries potentially important signals as to
future fed policy directions.
The relationship of this rate to the Federal Funds
rate has changed since January 2003.
Relationship of Discount Rate (Primary
Credit Rate) to Fed Funds Rate
Cross Country Comparisons: 10Year Gov’t Rates, May 2012
Country
10-Year Gov’t
Bonds (in local
currency)
Country
10-Year Gov’t
Bonds (in local
currency)
United States
1.76%
Italy
5.98%
Switzerland
0.65%
Spain
6.28%
Japan
0.83%
South Africa
7.78%
Hong Kong
1.12%
Ireland
8.21%
Germany
1.46%
India
8.52%
Singapore
1.46%
Turkey
9.31%
Canada
1.92%
Portugal
12.39%
United Kingdom
1.94%
Brazil
12.55%
China
2.80%
Pakistan
14.23%
France
2.88%
Greece
28.41%
Australia
3.23%
http://www.tradingeconomics.com/bonds-list-by-country
Why the Differences in Rates?

Differences in cross country government bond
interest rates reflect:
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Relative differences in economic growth (where countries
are in their business cycles).
Relative differences in rates of inflation (generally the
higher the rate of inflation, the higher the interest rate).
Relative differences in the “accommodative” stance of each
country’s central bank (generally the more accommodative,
the lower the interest rate)
Relative differences in the market’s assessment about the
risk associate with a sovereign borrower.
Impact of flight to safe havens as markets become risk
adverse (movement into “safer” countries during regional
and global uncertainty will drive down yields).
One quick way to observe and measure these
differences is through “spreads” to major country
bond rates.
Inflation and Long Term Interest
Rates
Safe Haven Effect: U.S. Dollar and
U.S. 10-Year Bond Rates
EURO Exchange Rate (in
USD)
10-Year Bond Rate (19192012 average = 6.6%)
Gov’t Rates: Spreads Over
Benchmark Rates
Country
Latest
Yield
Spread
Versus
Bund
Spread
Versus
T-Bond
Country
Latest
Yield
Spread
Versus
Bund
Spread
Versus TBond
United
States
1.75%
+0.30
-------
France
2.86%
+ 1.42
+ 1.11
Germany
1.45%
--------
-0.30
Australia
3.18%
+ 1.73
+ 1.43
Switzerland 0.65%
-0.80
-1.10
New
Zealand
3.59%
+ 2.14
+ 1.84
Japan
0.88%
-0.57
-0.87
Italy
5.96%
+ 4.51
+ 4.20
Denmark
1.33%
-0.12
-0.43
Spain
6.28%
+ 4.83
+ 4.53
United
Kingdom
1.85%
+0.40
+0.10
Portugal
12.39%
+10.94
+10.64
Canada
1.90%
+0.45
+0.15
Greece
28.90%
+27.45
+27.15
http://markets.ft.com/RESEARCH/Markets/Government-Bond-Spreads
What Do Spread Differences Tell
Us?



Given that the spreads are relative to the two major
default free sovereign borrowers (Germany and the
U.S.), perhaps we can use these spreads as a
market measure of risk of default (certainly the case
of Italy, Spain, Portugal and Greece).
On the other hand, spreads may simply represent
differences in inflation rates (Japan and U.K.),
economic activity (Australia), or central bank
accommodation (Switzerland).
Finally, differences between the Bund and T-Bill
probably reflect differences in global market demand
stemming from regional and global safe haven
effects.
Comparing Cross Country Interest
Rates

In comparing government bonds cross country,
the 2 most common comparison rates are either
yields to maturity on 10-year U.S. Treasuries (TBonds) and 10-year German Treasuries
(Bunds).


We assume both of these are “default-free.”
Thus we can compare other sovereigns to these
(and to one another) to assess :




Risk of default (credit risk).
Inflation risk.
Overall country risk (including political and exchange
rate risk)
See: http://markets.ft.com/markets/bonds.asp
Central Bank Overnight Interest Rate
Targets, January 2008 and May 2012
Country
January May 2012 Country
2008
United States
4.25%
0 – 0.25% India
Japan
0.50%
0.10
Switzerland
2.75%
Canada
Euro-zone
January
2008
May 2012
9.00%
8.00%
Egypt
11.50%
9.25%
0.00%
Brazil
13.75%
9.00%
4.00%
1.00%
Turkey
16.75%
5.75%
4.00%
1.00%
United Kingdom 5.50%
0.50%
Australia
6.75%
3.75%
China
7.20%
6.56%
New Zealand
8.25%
2.50%
http://www.fxstreet.com/fundamental/interest-rates-table
Cross Country Comparisons:
Money Market Rates (3 Month
Government Rates) May 2012
Country
Interest Rate (in
local currency)
Country
Interest Rate (in
local currency)
United States
0.07%
Australia
3.28%
Germany
0.06%
Brazil
8.44%
Japan
0.11%
Greece
United Kingdom
0.26%
Canada
1.00%
25.40%
Useful Web Sites

For current U.S. interest rate data see:


For Effective Fed Funds Rate see:


http://www.bloomberg.com/apps/quote?ticker=FEDL01:I
ND
For other key rates:


http://www.federalreserve.gov/releases/h15/update
http://www.bloomberg.com/markets/rates-bonds/keyrates/
For cross country comparisons on 10-Year
Government bonds:

http://www.tradingeconomics.com/bonds-list-by-country
Appendix 1
Ben Bernanke’s View of the Role of Central Banks:
The following slides present a brief sketch of
Bernanke and offer possible insights into his
approach regarding the role of the U.S. central
bank.
Ben Bernanke


Ben Bernanke was born on December 13, 1953, in
Augusta, Georgia. He received a B.A. in economics
in 1975 from Harvard University (summa cum laude)
and a Ph.D. in economics in 1979 from the
Massachusetts Institute of Technology.
Before becoming a member of the Federal Reserve
Board, Dr. Bernanke was the Howard Harrison and
Gabrielle Snyder Beck Professor of Economics and
Public Affairs and Chair of the Economics
Department at Princeton University (1996-2002). Dr.
Bernanke had served as a Professor of Economics
and Public Affairs at Princeton since 1985.
Bernanke’s Views on Central Banking

Bernanke, whose academic studies have focused on the
Great Depression, has written that during that era the U.S.
central bank allowed banks to fail, prices to fall and the
money supply to contract, which contributed to the
protracted slump.



In essence, he blames the Fed for not acting in a proactive
manner.
In addition, Bernanke has been quoted as follows: "We now
know the lessons from that” [the Depression]. "We are
certainly going to make sure that the financial system
remains in good functioning order.“
Conclusion: It appears that Bernanke will follow a very
aggressive proactive approach to monetary policy in the
U.S.
Appendix 2
Changing Fed Chairs being introduced
by the President
Changing Fed Chairs
Volcker to Greenspan,
August 1987
Greenspan to Bernanke,
February 2006